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Taxing Subject

Gift or Gift Horse?

By

Joseph F. Gelband

July 20, 1998 12:01 a.m. ET

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E state-planning programs center on disposing of property by means of gifts to avoid the higher tax cost of transferring it through an estate. The estate tax is based on the entire estate, including the portion used to pay the tax itself, while the gift tax is computed on the gift alone; thus, in the 50% unified estate/gift-tax bracket, it takes $1 million to provide $500,000 to your heirs, but only $750,000 to do it as a gift ($250,000 tax on a $500,000 gift), and even less if you can use the familiar annual $10,000 gift tax exclusion. And now, with the lower tax (20%) on long-term capital gains, compared with as much as 55% on assets included in an estate, the benefit of the tax-free basis step-up of estate property has lost much of its attraction. All of which tends to inspire gifts up to the last possible moment.

But when is a gift not a gift? The changing rules for gifts made near the end of a lifetime can be confusing. A little history may be useful. At common law, a transfer of property when the owner (the donor) believed he was dying (a gift "in contemplation of death") was effective only if he actually succumbed -- the gift was nullified if he recovered, and the property remained his. This was carried into the Tax Code, under which property given away "in contemplation of death" was, until recently, taxed as part of the donor's estate if he died within three years of the transfer. His motive for the gift (was he in apprehension of death?) was critical but often difficult to establish. The former IRS regulations required "the bodily and mental condition of the decedent and all other facts and circumstances to be scrutinized." It was an issue virtually made for litigation, and the unpredictable results varied widely. The motivation issue was finally resolved in 1976 when Congress enacted a uniform rule: All gifts made within the donor's last three years would be swept into his estate regardless of what he might have been contemplating, and no matter how feeble or vigorous he felt.

This three-year rule was discarded for most purposes by the Economic Recovery Tax Act of 1981. Nowadays, if you make an unconditional, outright gift, i.e., which the donee can get his hands on immediately, it will be recognized as such regardless of the state of your health, no matter what you apprehend or contemplate, or how long afterwards you remain in this vale of tears.

There is an exception for gifts of life insurance made during the three years preceding your death -- the proceeds will be included in your estate just as though you still owned the policy. However, merely paying premiums is okay. Suppose, for example, you assigned the policy to your child five years ago, and continue to pay the premiums right up to the end. Will there be an estate tax on the proceeds? The Internal Revenue Service has ruled, in effect, that merely paying the premiums on an automatically continuing policy will not bring the proceeds into your estate; the gift will be recognized as such. But make sure the assignment covers all your rights in the policy, including, for example, the right to change the beneficiary or the manner in which the proceeds will be paid, to surrender the policy or to borrow against it. The proceeds will be taxed in your estate if you retain any such right.

The three-year rule still applies to gifts with strings attached, as, for example, transfers of property (usually in trust) subject to your receiving the income, or to your right to take it back by revoking or amending the trust, etc. All such property will be included in your estate unless you release the strings more than three years before your death.

The recent removal of a trap will be appreciated by those who have set up "living trusts." The creation of such a trust (usually intended to bypass probate proceedings), which you retain the right to revoke, is not taxable as a gift; your right to revoke the trust is equivalent to owning the trust property. Still, if you instructed the trustee to transfer some of the trust assets, say, as a gift to your child, thus "releasing the strings" on those assets, the gift (including any future increase in its value, with no benefit of the $10,000 annual exclusion) could be included in your estate in case of your death within three years (there were conflicting decisions on this issue). Many grantors were caught in the trap, one you could avoid (if you knew about it) by first withdrawing assets from the trust and then making the gift yourself (as noted, an outright gift is not added back to your estate regardless of your longevity). The 1997 Act made this step unnecessary; a transfer from your revocable trust will be treated as a gift from you.

The three-year rule also survives to block the use of the gift tax on last-minute, deathbed gifts as a way to lighten the taxable estate. Before the 1976 amendment, although a gift made with the donor's last breath was included in his estate, the gift tax was not. The Tax Code now requires an estate to be increased, or "grossed up," by taxes paid " on any gifts made by the decedent or his spouse during the three-year period ending on the date of the decedent's death." But note the hook: The gross-up applies not only to your gifts, but also to any tax you pay on a gift by your spouse. So it's better to give her the money (no tax on gifts between spouses) and have her pay the tax herself. It seems like a waste of motion, but it could save some estate taxes.

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